Regulatory Tools and Price Changes in Futures Markets

There is an extant literature investigating the relation between futures price limits and the volatility of futures price changes. An equally impressive number of papers investigates margin levels and their relation with price volatility. Very few papers explicitly model the indirect relation, through volatility, between margins and limits. Brennan's (1986) model is an exception. In his model, price limits help control contract default risk, thereby reducing required margins and ultimately lead to lower transaction costs. The crucial assumption in Brennan's model is the absence of accurate price signals when prices are locked at the limit. The paper extends Brennan's model with more realistic price change distributions that capture the typical characteristics of futures prices such as fat tails and time-varying volatility. It also discusses how learning can occur and how this may affect cost minimising optimality of regulation.